Opportunity ahead for mortgage REITs as bond market calms

Last week was very light data-wise, so the bond market had some time to digest the data from the past couple of weeks. On the lack of data, the ten-year bond yield dropped by a couple of basis points, while the Bankrate average 30-year mortgage rate fell by 7 basis points. While the ten-year bond yield has been close to its highs recently, mortgage rates are much lower than their peak levels in early July. Part of this is due to diminished REIT selling of TBAs and some of it’s due to promotional activity from originators, as they cut margins to drive business.

The refinance boom is pretty much over. The only thing that will get it going again is a policy move, such as an expansion of HARP (the Home Affordable Refinance Program).

The purchase market is much more relationship-driven than the refi market. This market requires a branch system of local professionals who have a large network of realtors, real estate attorneys, and similar professionals. These bankers compete on the basis of price and service. This also means there’s competition for independent brokers and bankers. A mortgage banker can grow very quickly through M&A (mergers and acquisitions) activity.

The private label market is finally returning, although credit is still tight

The mortgage market is undergoing a massive transformation as the private label mortgage market returns. Bob Corker (R-TN) and Mark Warner (D-VA) recently introduced a bill to end GSEs (government-sponsored enterprises) and put the government in a re-insurance role. All the securitization that was done by Fannie Mae and Freddie Mac will now be done by private entities, some of whom could be mortgage REITs. Yesterday, President Obama laid out his plan for the future of mortgage origination, and it looked very similar to the Corker Warner bill.

Since the bubble burst, mortgage origination has been almost exclusively government-driven. The big buyers of new origination have been the agency REITs like Annaly (NLY) and American Capital (AGNC). The U.S. government bears 50% of the credit risk of the entire U.S. mortgage market. Originators typically don’t hold their mortgages: they either sell them to the big banks or securitize them. Since the securitization market has been dead, originators have no outlet for non-agency mortgages. Redwood Trust (RWT) has been the only issuer of private-label mortgage-backed securities (securities backed by mortgages that aren’t government-guaranteed), and it has focused exclusively on high-quality jumbo loans. Pennymac (PMT) noted on its call that origination increased nicely in the second quarter. Still, it’s clear that the origination business is getting more competitive, and mortgage rates are dropping as lenders cut price—even if credit is still very tight.

In the beginning of the year, we saw a wave of private label deals, but they subsequently halted as rates began to increase. We’re finally starting to see private label deals again—mainly from issuers like Redwood Trust, although some hedge funds are selling re-performing mortgages (but these deals are highly overcollateralized). This is good for REITs that have large legacy portfolios of non-performing mortgages and re-performers like Impac (IMH). Finally, increases in origination will help servicers like Nationstar (NSM) and Ocwen (OCN).

Where’s the next opportunity going to be? Stated income and Alt-A type deals. Mortgage REITs have one big advantage that most issuers don’t have: access to permanent capital. They don’t require a warehouse line of credit from a bank to fund mortgages. This means no competition from small independent mortgage bankers—or from the large banks, which are doing fine just sticking with vanilla loans.

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